The Economy Keeps Fighting the Fed, and Winning

The economy is growing at a solid rate despite the fastest tightening of monetary policy in 40 years. Don’t expect the growth rate to continue.

At almost any other time, the rapid tightening of monetary policy the Federal Reserve engineered in 2022 and 2023 would have triggered a serious recession or, at a minimum, stalled the economy.

While the most interest-rate sensitive and speculative sectors of the economy and markets suffered, most of the economy has held up well.

The unemployment rate remains low, with a large number of job openings throughout the economy. Wages and compensation continue to increase faster than the average of the last 20 years. Consumer spending on goods and services is unabated.

Stocks rebounded from their 2022 lows, and housing prices remain strong despite higher mortgage interest rates. Those moves act as stimulus by increasing household wealth and consumer confidence.

All those factors keep inflation above the Fed’s target.

That’s why the Fed will continue its tight monetary policy. It might stop increasing interest rates, at least for a while, but won’t decrease rates for some time, absent a major economic or financial downturn. This is contrary to expectations in the futures markets that interest rates will begin a steady descent in mid-2024.

The Fed is reducing the amount of bonds and mortgages on its balance sheet, putting more pressure on bond markets.

Several factors kept the economy from stalling in the face of tighter monetary policy during the last two years.

Households and businesses were in better financial shape and less leveraged than they usually are when the Fed tightens monetary policy.

The Treasury Department was able to manipulate its finances to issue primarily short-term treasury notes instead of bonds. That kept intermediate- and long-term interest rates from rising as much as short-term rates.

But those and other factors have almost played out. Short-term interest rates are going to stay near recent levels for some time, and other interest rates should rise.

Economic growth gradually will feel the effects. Businesses will have to refinance debts as they mature and pay higher rates on new debt. Households also will experience the effects of higher rates over time.

Those factors gradually should reduce employment, wage increases and consumer spending. I don’t see a rapid decline in the works, but growth should slow in fits and starts.

Stock prices recovered from the lows of October 2022. But they’re still well below the peak of late 2021.

The primary boost for stock prices for most of 2023 was that investors believed the Fed was on the verge of reducing interest rates. The excitement over artificial intelligence also boosted stock indexes.

In 2024, stock prices will have more headwinds than they had in 2023.

As I said, higher interest rates will reduce cash flow as businesses roll over debt. The tight labor market and the higher wages that come with it will continue to crimp profit margins and then stock prices. Because of the sticky inflation of the last two years, businesses are paying higher prices for most inputs in addition to labor.

Reduced globalization decreases sales as well as opportunities to contain costs through outsourcing. Government policies throughout the world are less favorable to businesses than they’ve been in decades. And businesses face additional costs imposed by efforts to respond to climate change.

These headwinds, plus high stock valuations, make it unlikely the indexes are on the verge of a sustained return to record price levels. I don’t expect stocks to crash. It is more likely that prices will stall and gradually fall.